The first quarter of 2020 will forever be remembered for the great coronavirus crash. After entering the year with continued momentum from 2019, the economy plunged into recession over the course of two weeks in March as the authorities enforced “social distancing” and shut down non-essential businesses to prevent the infectious COVID-19 health pandemic from overwhelming our health care system.
Health pandemics are not unprecedented; the last of significance occurred in 1918 when the Spanish flu killed far more people across the country and world than even the most dire forecasts project for this pandemic. What is stunning, however, is the speed with which economic activity has been forced to a standstill, causing unemployment claims to spike on a breathtaking scale. The dynamics which normally turn an expansion into a recession take 12 to 18 months to unfold, not fewer than 14 days.
This “jump to an instant recession” caused violent dislocations across capital markets amid levels of volatility surpassing those of the Great Financial Crisis. Short-term interest rates collapsed to zero as the Federal Reserve (drawing on the playbook it developed in 2008-09) lowered its policy rate to the floor, pledged to buy assets in unlimited quantities, and backstopped the corporate and municipal bond markets to provide liquidity to markets so they would continue to function. Corporate and municipal credit spreads widened, especially for lower-quality credits as investors began to price in a greater likelihood of defaults. Corporate bond spreads in the energy sector widened dramatically as oil prices collapsed under the weight of OPEC failing to reach agreement to limit supply. Global stock markets convulsed with the S&P 500 falling by more than 35% from a record-high peak to trough before stabilizing to end the quarter down about 25%. Small cap stocks and international stocks, especially emerging markets, were hit even harder.
By the end of the quarter and into the first week of April, there were encouraging signs that social distancing and other initiatives were helping to “flatten the curve” and slow the trajectory of the pandemic to buy enough time for doctors and scientists to find medicinal therapies while the economy begins to restart in a limited way. China, where the virus originated, was already beginning to reignite its economic engine. South Korea, Germany, particularly devastated areas such as Italy and Spain, as well as the bellwether state of New York for the broader U.S. region, were all showing signs that the rate of new infections and deaths were beginning to decline. A common pattern appears to have emerged: the swifter and more decisively authorities have acted, the quicker the health crisis in their areas has peaked.
The question for now is—until such time as game-changing medicine is discovered—how quickly can the economy and markets recover from this dramatic, sudden, exogenous shock? Will activity snap back quickly, allowing for a V-shaped recovery? Will it be a long, U-shaped, drawn-out process taking six months or more? Or worse, will the virus mutate and come back over the fall, snuffing out any premature recovery and following more of a W-shape? Capital markets will continue to look through current grim headlines to discount the likely timing and shape of the recovery.
A lot is going to depend on how authorities are able to restart the economy in a responsible and timely way by making testing readily available, providing sufficient protective equipment to those on the front lines in our health system, and ensuring social distancing guidelines are enforced. Before we assess the outlook, let’s evaluate how portfolios have weathered the storm.
Quarter in Review
Our longstanding policy of keeping two years’ worth of distributions from portfolios (to meet spending, tax, and capital call needs) in cash and short-duration fixed income have helped clients avoid the need to capitulate during moments of peak panic. Our clients know they have two years to ride out this pandemic without having to disturb their investments and risk permanently impairing capital. We have always stressed the importance of investing cash safely (e.g., in all Treasury money market funds or bank deposits spread across several institutions to take advantage of FDIC insurance) rather than blindly chasing yield. During the peak of the panic, there were concerns about money market funds with lower credit quality “breaking the buck” before the Federal Reserve announced it was backstopping them. A disciplined cash reserve policy and implementation across your entire balance sheet is always the first and most important line of defense against sudden, unanticipated, exogenous shocks.
The fixed income we have in portfolios is of high quality. Fixed income provides a ballast to portfolio volatility and its quality should not be compromised. As a result, we have avoided the significant distress high-yield corporate and municipal bonds have experienced. These areas have not yet become the generational investment opportunities we seized upon in 2009 when markets were incorrectly pricing in a depression.
Amid record-low unemployment, continued earnings growth, tame inflation, abating trade concerns, and the relatively uncompelling case for fixed income, our portfolios were positioned with a significant weighting toward equity markets as the crisis suddenly erupted. Our tactical overweighting of equities during this quarter has hurt portfolios after the strong outperformance it generated during 2019. However, our equity exposure has held up very well relative to the broader markets, helping to protect portfolios meaningfully.
Despite how it may feel after the dramatic days of March and early April, equity markets have calmed significantly, with the Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX) dropping to the 45-55 range. While still elevated, these levels are a far cry from the March 18 peak of 81. This is important, because it signals the initial panic phase of the coronavirus market has ended.
Unlike 2008, the Federal Reserve and administration have acted quickly to blunt the potential of this sudden economic shock to become a systemic liquidity and solvency crisis. Acknowledging that it will take some time to recognize when the rate of new coronavirus infections has begun to slow, they are using all their policy weapons to ensure capital markets are functioning while stimulating economic demand to limit the economic fallout.
Our recent communications have cautioned against becoming captive to the emotional moment. Our process is designed to lead us to make unemotional decisions, as selling amid market panic is rarely, if ever, a profitable strategy. It is conceivable (based on our projected decline in GDP during the coming sharp recession and a likely contraction in the multiple of equity market capitalization to GDP) that the S&P 500 Index could decline to between 2000-2050 before a bottom is decisively made. Therefore, there is the possibility for more downside in the short-term, but we believe most of the damage has already occurred for stock markets and the remaining downside is relatively limited.
Now that the panic phase has ended, we are assessing the outlook, allowing us to make rational investment decisions. We continue to monitor our models, as always. Our conclusion remains that it is still too early to play outright offense, but we are staying alert to opportunities. While there are certainly tempting assets which have fallen precipitously, the price declines have been warranted, and we do not believe the potential reward justifies the potential risk at this point.
Overall, the trajectory of the broader stock market continues to parallel what we saw in 1987, which reaffirms the notion that bottoming is a time-consuming process. The difference is there was no recession in 1987, but we are in one now. With that said, this year’s recession should be deep and fast, and thus a quicker-than-normal post-recession recovery is likely to ensue. The time necessary for the stock market to recover its previous peak after the most recent recessions was 48 months (after 2002) and 37 months (after 2009). As such, we would estimate it will take longer than the 17 months necessary from the 1987 crash but shorter than the 37 months required after 2009.
Many are discussing the possibility of a V-, a U-, a W-, or maybe even an L-shaped future trajectory. History shows that exogenous shocks, which are relatively rare, typically hit the economy harder in the short-term because of their randomness leading to chaos and panic. However, unless they lead to structural problems, they generally bounce back more quickly.
We believe the coronavirus will impair certain industries, likely to the point of bankruptcy in some cases. However, we expect the decisive and timely fiscal and monetary stimulus to be effective in providing a bridge to the other side of the crisis, leading to a relatively quick rebound for those industries which were not permanently impaired. Selectively, there will be fallout for companies which were overleveraged, even if their industries are not as hard hit. Unfortunately, crises often serve as a reminder of the pitfalls of using excessive leverage no matter how strong the economy may be at the time. Investors must remain cautious of the yet unknown second- and third-derivative effects of this unprecedented global event.
Given the severe and sudden dislocation imposed on all asset classes generally enjoying sound fundamentals a month ago, several opportunities abound. The expected return from an intelligently diversified portfolio is higher today than when we published this January’s edition of our annual Capital Markets Forecasts. Over the intermediate term, the key question is whether the stock market has moved to discount earnings, dividends, and share buy-back cuts more aggressively than the outlook warrants. This, alongside whether the yield curve is able to remain positively sloped without interest rates falling into negative territory, will be key to whether the stock market and risk markets, in general, offer the relative value they appear to offer today over the intermediate term. It is still too early to tell. For those impatiently itching to pull the trigger, we remind you that inaction is a proactive choice. There will be plenty of opportunity in the future to reap the rewards of this crisis once the data objectively confirm the worst is behind us.
Our team is committed to communicating, at the risk of excess, with you as this crisis unfolds. It remains a very fluid and rapidly evolving situation. We will keep you updated as our views change. In the meantime, please let us know if you have any questions.